Quarterly Letter
“Only when the tide goes out do you discover who has been swimming naked.”
– Warren Buffett
Every few years a financial crisis arises that brings to mind this famous Warren Buffett quote. The trigger this time was Silicon Valley Bank – until recently a media darling, whose success has now been exposed as being built on imprudent low interest rate bets and a massive overexposure to the venture capital and technology industries. It was a strategy that worked brilliantly . . . until it didn’t. Once the economy cooled, clients began making significant withdrawals from their accounts. In order to meet the cash demand, the bank needed to sell bonds in its portfolio. This is when the problem arose, as Silicon Valley Bank had bought very long-term bonds to squeeze extra returns at a time of very low interest rates. Given the jump in interest rates, however, those bonds were now priced at a huge discount to face value. In other words, Silicon Valley Bank was sitting on billions of dollars of unrealized losses that needed to be realized. As word spread of the significance of the losses, a classic “run on the bank” began, and Silicon Valley Bank had nowhere to hide, except via a government takeover.
Initial fears of contagion, meaning a run on others within the banking sector, have proven to be unwarranted. While the economic impact so far has been negligible, there is no doubt that ramifications from the debacle will have a somewhat chilling effect on the markets for a time. Events like this undermine confidence in the economy. Nevertheless, March ended on a positive note with market rallies that carried most stock and bond indices into positive territory for the quarter, a welcome turnaround after the widespread underperformance of stocks, bonds and real estate in 2022. The rally in equities has been narrow, however, and the average stock is up less than one percent year-to-date.
Notwithstanding banking concerns, the big story for investors remains inflation, which persists at uncomfortably high levels. Getting a handle on inflation is a challenge, as actions by the Fed take quarters, or even years, to achieve their full effect. Thus, the Fed is in the difficult position of trying not to do too much in raising interest rates, while also not doing too little. Unfortunately, their efforts will be further complicated, in all likelihood, by debt ceiling debates this spring, which will likely peak in June. Lawmakers will need – despite all their protestations to the contrary – to compromise and suspend or raise the debt ceiling limits. The fact that this needs to happen is not debatable, and it is hardly the first time it has been necessary. Since 1960, Congress has acted no less than seventy-eight times (!) to revise the debt limit, and under both Democratic and Republican administrations. The one time things were pushed to the absolute limit was in 2011, and that ended badly, with significant consternation experienced by the markets, and a downgrade of the rating of US Treasury debt. We do not want that to happen again.
Humorist Erma Bombeck many years ago noted, “It may seem rather incongruous that in a society of super sophisticated communication, we often suffer from a shortage of listeners.” We hope that our elected representatives, Federal Reserve governors, and other senior officials take Erma’s thoughts to heart. For, if they listen to markets and the supporting data, they might note that while times are relatively good, headwinds are building . . . The banking crisis may be controlled, but it is still a big deal. Money supply indicators have shrunk dramatically, usually a sign of economic slowdown. Housing prices began their decline in the fall of 2022, and the downward trend has continued for seven consecutive months. All of this, of course, is heavily influenced by the big jump in interest rates, as the Fed has raised rates over the past year from near zero to 4.75 percent. As a result, the yield curve is significantly inverted, meaning short-term interest rates are higher than long-term rates – historically, that is not a good sign. In addition, oil prices, while down from their peak, remain high, and corporate earnings have been flattish-to-down the past several months. All this provides ample evidence that a recession likely looms in the future. Given this, our hope is that the Fed puts a pause on additional interest rate increases for a time to allow their prior actions, as they say, to work their way through the python.
It still looks to be a market where bad news will continue to be good news for a time, and good news to be bad. If unemployment goes up, for example, something bad for those needing work, the market will likely take it as good news; an indication that further interest rate increases may not be necessary. Likewise, if corporate earnings are weak, something that is bad in the short-term for business, it could be taken as a signal to the Fed that its actions are working, and that inflation should cool. These are, as they say, interesting times.
In spite of this, history teaches us the stock market tends to turn upward long before recessions end, a phenomenon many successful investors have observed before. In fact, a study of the most successful investors in history reflects a few common traits. Importantly, they have what Michelangelo termed, “the genius of eternal patience.” They know that periodic downturns are as normal as breathing in and out, and they do not let short-term emotional impulses push them into ill-timed long-term decisions. Indeed, some, like Warren Buffett, have confessed that while they did not realize it at the time, they made their best investments during recessions.
Clients frequently mention to us how troubled recent years seem. They do, of course. However, as we have noted before, when have they not? There are few times in American and World history when there was not social upheaval, armed conflict, economic turbulence and political divide. Through it all, patient investors in quality companies and diversified portfolios have experienced outstanding returns relative to inflation or other investment options. While current market troubles could last for several more quarters, we continue to stay the course. Markets usually turn long before positive news is reported, and we need to stay invested to reap the rewards when that happens.
Indeed, some, like Warren Buffett, have confessed that while they did not realize it at the time, they made their best investments during recessions.
Market Commentary
- After a challenging 2022, stock markets rebounded during the first quarter of 2023, although gains were far from “linear.” Markets gyrated given stubbornly high inflation, a relatively strong job market, Federal Reserve rate hikes, a banking crisis, and flattish, but still better than expected, corporate earnings.
- U.S. Large Cap stocks, as measured by the S&P 500, are up 7% year-to-date, while Small Cap stocks are up 3%. Good performance was concentrated, however, primarily in the rebounding Tech sector, and the average U.S. stock was up under 1% in the first quarter. International Developed and Emerging Markets stocks climbed 8% and 4%, respectively. Battered in 2022, Growth stocks led, while Value and dividend-oriented strategies lagged the broader market.
- Though the Fed has raised interest rates twice year-to-date, many expect rate hikes to soon end, contributing to overall market optimism in the first quarter. Going forward, the Fed is in the difficult position of trying not to do too much while also not doing too little. This is a challenge because actions taken by the Fed take quarters, if not years, to see their full effect.
The Battle Against Inflation Rages On
- To quash inflation, the Federal Reserve increased interest rates twice in the first quarter, continuing the most rapid rate-hiking cycle in history. Higher interest rates create headwinds for consumer and business spending.
- The effects of the Fed’s policy tightening, which always lag, have begun to be reflected in moderating inflation figures. Consumer prices, such as food, automobiles and housing have shown signs of cooling. That is critical because consumer spending accounts for roughly two-thirds of U.S. GDP. Some of the decline is also due to global supply chain pressures dissipating, as seen in the lower right chart.
- Most currently expect a terminal Fed Funds target interest rate of 5.25%. (It is currently 4.75% – 5.00%.) Lest anyone assume that will be the actual target, recall in late 2021 the Fed forecasted no interest rate increases for 2022.
An Unyielding Fed
- As the Federal Reserve has aggressively hiked interest rates, the 2-year and 10-Year Treasury note yields have risen from 0.78% and 1.63%, respectively, since the beginning of 2022, to 4.06% and 3.48%, at the end of the first quarter. The resulting inverted yield curve, graphically shown in the chart to the right, is fairly pronounced.
- Inverted yield curves have historically been a reliable indicator for a recession in coming quarters. Of note, recessions typically begin around the same time the Fed “pivots” or begins cutting rates (effectively normalizing the yield curve), which has yet to happen, as seen in the chart on the lower left.
- The increase in bond yields could be viewed as a positive relative to the past 15 years of ultra-low bond interest rate returns. As the spread between government-backed, corporate, and non-investment grade bonds widens, there are more options for investors to earn higher rates and lower their duration risk.
New Chapter for International Equities
- The U.S. dollar has shown signs of weakening after reaching a 20-year high in 2022. A weakening dollar, even marginally, could provide a backdrop for international equity outperformance, particularly for U.S. domiciled investors.
- For more than a decade, U.S. equities outperformed international equities, largely due to a stronger U.S. economy. That streak came to an end in 2022. Relative valuations for international equities seem to offer attractive opportunities for long-term investors.
Recessions, In Perspective
- The U.S. economy may enter a recession later this year, or early in 2024. Nevertheless, one can make a solid argument for a positive outlook for stocks, or a negative one:
- The Positives: Inflation is cooling, valuations have generally fallen from relatively high to fair value, businesses are still highly profitable (albeit with short-term earnings growth challenges), and labor market data remains strong.
- The Negatives: A coming debt ceiling debate, potential for expanded war in Europe or Asia, possibility of a broadening banking crisis, and flat-to-negative earnings growth for a few more quarters.
Contributors
© 2023 The Finerty Team
The S&P 500 Index is a free-float capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the United States. The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
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